Monday, 26 November 2012

A business valuation determines the estimated market
value of a business entity. A valuation estimates the complex economic benefits
that arise from combining a group of physical assets with a group of intangible
assets of the business as a going concern. The valuation, which is part art and
part science, estimates the price that hypothetical informed buyers and sellers
would negotiate at arms length for an entire business or a partial equity
interest.

Valuation vs. Appraisal: How Do They Differ?

Valuation and appraisals are similar, but they are not
interchangeable. Most people are familiar with appraisals in their personal
lives. Often times people will have appraisals performed on a house, a car or a
piece of jewelry. The key difference between a valuation and an appraisal is
that a valuation includes both tangible and intangible assets, while an
appraisal just includes tangible or physical assets.

Business Valuation: Art or Science?

A business valuation combines quantitative financial
techniques with qualitative analysis of the business, the industry and the
economic conditions in general.

How can you determine the value of your closely held
stock?

The successful valuation of a closely held security
requires:

determining the proposed use of the valuation option

defining the meaning of the term "value"
which is appropriate for the proposed use of the opinion

analyzing and pricing the business enterprise
underlying the closely held security being valued

Analyzing and pricing the specific block of securities
being valued.

Reasons for Business Valuations

·To establish a price for a transaction

·Business planning

·Attract capital

·Aid in estate and gift planning

·Meet governmental requirements

·Buying or selling a full or partial interest in a
business

·A business merger or acquisition

·Admission or retirement of a partner in a business

·Property division in a divorce, when marital property
includes an interest in a business

·Payment of estate or inheritance taxes involving an
interest in a business

·Estate planning

·Preparing personal financial statements including an
interest in a business

·Employee Stock Ownership Plans (ESOPS) require
valuation of employer securities upon their acquisition by an ESOP, and at
least annually thereafter, under the Employee Retirement Income Security Act of
1974 (ERISA) and the Internal Revenue Code.

·Dispute resolution in cases where damages must be
determined for lost value of a business, such as breach of contract, patent
infringement, franchise disputes, antitrust suits, eminent domain, lender
liability, and dissenting stockholder suits.

The Components of a Business Valuation

IRS Revenue Ruling 59-60 states that valuations should
address the following issues:

·The nature and history of the business

·The general economic outlook and the conditions of the
specific industry

·The book value of the stock

·The financial condition of the company

·The Components of a Business Valuation

·The earnings capacity of the company

·The dividend paying capacity of the company

·Whether the company has goodwill or other intangible
value

·Previous sales of stock

·The market price of publicly traded companies who are
engaged in the same or similar lines of business

How is a Business Valuation Conducted?

The business valuation process can be broken down into
four components.

·Engagement process

·Research and data gathering

·Analysis and estimate of value

·Reporting Engagement Process

Issues in valuation

There are several issues that must be addressed at the
start of the business valuation process.

·Definition of the legal interest to be valued - (e.g.,
100% of the company's common stock)

·Valuation date - the date of the estimate of value

·Purpose of the valuation (e.g., estate tax, sale of a
business, business planning, etc.)

·Define standard of value: Fair market
value - the value in an exchange between a willing buyer and a willing
seller with a reasonable understanding of the facts. Fair market value is the
most common standard of value and the IRS requires it;Investment value -
the value to a particular investor based on individual investment requirements.
This standard is often used in merger transactions.

·Define the premise of value: Value as a going
concern - this is the value of a business assuming it will continue to
operate as a going concern; Liquidation value - this is the value of
a business that is not operating as a going concern, but has commenced an
orderly disposition of its assets.

·Form and content of the report

The standard of value

The standard of value is the type of value involved,
for example:

1.Book value,

2.Investment value, or

3.Fair market value.

Book Value

Book value is the amount reflected in the financial
statements for owner equity (assets less liabilities). The assets are usually
stated at historic cost, reduced by appropriate allowances for:

depreciation or amortization (in the case of
depreciable fixed assets),

Investment value is value to a specific individual
investor, as opposed to an objective impersonal market value to investors at
large. For instance, a uranium mine is probably worth more to a purchaser who
has access to nuclear technology than to a purchaser who lacks such access. A
steel plant that emits excessive pollution is probably worth more in a region
that has no anti-pollution restrictions than in a region with strict
environmental laws. The concept of investment value is value-in-use, rather
than value-in-exchange, which is market value.

Fair Value

This term means whatever it is defined to mean by the
relevant case or statute law, or industry trade practice or some other source.

Fair market
value is the most widely accepted standard of value used in business
valuations. It is the legal standard in virtually all business valuations for
federal and state tax purposes, and it is the standard for most other types of
business valuations, except in cases where a different standard is expressly
agreed upon or imposed by some legal requirement.

The Standard of Value and The Premise of Value

Whatever the premise of value may be, it can still
involve the fair market value standard with its “willing buyer(s)” and “willing
seller(s)”. Willing buyers and sellers can agree on transactions that are
composite or piecemeal, and on an orderly or forced liquidation basis.
Therefore the standard of value is not to be confused with the premise of
value. Despite some similarity in name, the standard of value is separate and
distinct from the premise of value. In order to keep these two important
concepts apart in our minds, it may be helpful to review the following summary:

Asset approach to valuing a business

The Asset approach methods seek to
determine the business value based on the value of its assets. The idea is to
determine the business value based on the fair market value of its
assets less its liabilities.

The commonly used valuation methods under this
approach are:

1.Asset accumulation method

2.Capitalized excess earnings method

Asset approach

The asset approach views the business as a set
of assets and liabilitiesthat are used as building
blocks to construct the picture of business value. The asset approach is based
on the so-called economic principle of substitution which addresses this
question:

What will it cost to create another business like this
one that will produce the same economic benefits for its owners?

Since every operating business has assets and
liabilities, a natural way to address this question is to determine the value
of these assets and liabilities. The difference is the business value.

Sounds simple enough, but the challenge is in the
details: figuring out what assets and liabilities to include in the valuation,
choosing a standard of measuring their value, and then actually determining
what each asset and liability is worth.

Market business valuation

The stats, expert opinions or both Market-based business
valuation methods are routinely used by business owners, buyers and
their professional advisors to determine the business worth. This is especially
so when a business sale transaction is planned. After all, if you plan to buy
or sell your business, it is a good idea to check what the market thinks about
the selling price of similar businesses.

The market approach offers the view of business
market value that is both easy to grasp and straightforward to apply.
The idea is to compare your business to similar businesses that have actually
sold.

If the comparison is relevant, you can gain valuable
insights about the kind of price your business would fetch in the marketplace.
You can use the market-based business valuation methods to get
a quick sanity check pricing estimate or as a compelling
market evidence of the likely business selling price.

Valuing a Business based on Market Comps

Pricing multiples for business selling price
estimation

All business valuation methods under the market
approach fall within one or more of the following categories:

Empirical, using comparative business sale data.

Empirical, which rely upon guideline public company
data.

Heuristic, which use expert opinions of professional
practitioners.

Income-based business valuation

To capitalize or discount?

A quick look at business valuation under
the income approach shows that you have two key types of
methods available:

Earnings capitalization methods.

Income stream discounting methods.

Given these two ways of doing the same thing you may
wonder:

Do these methods give the same business valuation
results?

Are there situations when capitalization or
discounting methods are preferred?

there are specific situations when these two types of
business valuation methods produce identical results. Strictly speaking, the
following is true:

if the business earnings are unchanged or grow at a
constant rate year to year, then the capitalization and discountingbusiness
valuation methods are equivalent.

Business Appraisal by Discounting its Cash Flow

This offers some useful insights:

You can use the current year's business earnings and
earnings growth rate as your business valuation inputs.

The capitalization rate is just the
difference between the discount rate and the business earnings
growth rate.

Business Valuation by Capitalized Multiple of Earnings

If business earnings vary significantly over time,
your best bet is to rely on discounting when valuing a
business. Since you can make accurate earnings projections only so far into the
future, the typical procedure is this:

Make your business earnings projections, e.g. 3-5
years into the future.

Assume that at the end of this period business
earnings will continue growing at a constant rate.

Discount your projected business earnings.

Capitalize the earnings beyond this point. This gives you the so-called
residual or terminal business value.

Capital extended for a term of greater than a
year. In both investing and personal finance, long-term financing
often takes the form of a loan with a payback period of longer than
one year. Examples of long-term financing include a 30 year mortgage or
a 10-year Treasury note. Equity is another form of long-term
financing, such as when a company issues stock to raise capital for a
new project.

Long Term Finance – Its meaning and
purpose

A business requires funds to purchase fixed assets
like land and building,

plant and machinery, furniture etc. These assets may
be regarded as the

foundation of a business. The capital required for these
assets is called

fixed capital. A part of the working capital is also
of a permanent nature.

Funds required for this part of the working capital
and for fixed capital

is called long term finance.

Purpose of long term finance:

To Finance fixed assets :

To finance the permanent part of working capital:

To finance
growth and expansion of business:

Factors determining long-term financial
requirements :

Nature of Business

Nature of goods
produced

Technology used

Sources of long term finance

The main sources of long term finance are as follows:

Shares:

These are issued to the general public. These may be
of two types:

(i) Equity and (ii) Preference. The holders of shares
are the owners

of the business.

Debentures:

These are also issued to the general public. The
holders of

debentures are the creditors of the company.

Public Deposits :

General public also like to deposit their savings with
a popular and well established company which can pay interest periodically and
pay-back the deposit when due.

Whereas short-term loans are repaid in a
period of weeks or months, intermediate-term loans are scheduled for repayment
in 1 to 15 years. Obligations due in 15 or more years are thought of as
long-term debt. The major forms of intermediate-term financing include
(1) term loans, (2) conditional sales contracts, and (3) lease financing.

Economic Role of a debt

What Business Owners Need

Before giving business owners
intermediate-term loans, banks want to know how much capital the businesses
have. Lenders want to see assets that can be turned into cash quickly. Lenders
can rely on these liquid assets to repay their loans in the event that a
business owner defaults on payments. A business owner's capital may include
apartment buildings, other real estate and stocks.

A Strong Business Plan

Lenders will also want to see a strong
business plan before lending money. They'll be especially interested in the
expenses and revenues that business owners project for their ventures. If these
figures seem poorly researched, the odds are good that lenders will pass.

Definition of 'Term Loan

A loan from a bank for a specific
amount that has a specified repayment schedule and a floating
interest rate. Term loans almost always mature between
one and 10 years.

For example many banks have term-loan
programs that can offer small businesses the cash they need to
operate from month to month. Often a small business will use the cash from a
term loan to purchase fixed assets such as equipment used in its
production process.

Characteristics of term loan

Credit is extended under a formal loan
arrangement.

Usually payments that cover both interest
and principal are made quarterly, semiannually, or annually.

The repayment schedule is geared to the
borrower’s cash-flow ability and may be amortized or have a balloon payment.

Conditional Sales Contracts

A sale of an asset in
which the buyer assumes possession and may have use of the
asset, but the seller retains title until the
buyer pays its full price and may repossess
the asset if the buyer does not. In exchange for the right to use the asset,
the buyer makes payments over an agreed-upon period of time,
whether months or years. This arrangement is most common with heavy equipment,
machinery, and real estate.

lease

Definition

Written or implied contract by
which an owner (the lessor) of a specific asset (such
as a parcel of land, building, equipment,
or machinery) grants a second party (the lessee)
the right to its exclusive possession and use
for a specific period and under specified conditions,
in return for specified periodic rental or lease
payments. A long-term written lease (also called a deed) creates a leasehold
interest which in itself can be traded or mortgaged, and is shown as
a capital asset in a firm's books.

Advantages of Leasing:

Leasing offersfixed
ratefinancing; you pay at
the same rate each month

Leasing isinflation
friendly. As the costs go up over five years, you still pay the same rate
as when you began the lease, therefore making your dollar stretch farther.There
is less upfront cash outlay; you do not need to make large cash payments for
the purchase of needed equipment.

Leasingbetter
utilizes equipment; you lease and pay for equipment only for the time you
need it (until the end of the lease).

There is typically anoption
to buyequipment at end of
the term of the lease

Youcan
keep upgrading; as new equipment becomes available you can upgrade to the
latest models each time your lease ends

It iseasier
to obtain lease financingthan
loans from commercial lenders (in most cases).

It offerspotential
tax benefitsdepending on how
the lease is structured.



Disadvantages of Leasing:

Leasing is a preferred means of financing
for many businesses. However, it is not for every business. The type of
industry and type of equipment required also need to be considered. Tax
implications also need to be compared between leasing and purchasing equipment
outright.You have an obligation to continue making payments. Typically, leases may
not be terminated before the original term is completed. The renter is
responsible for paying off the lease. This can create a major financial problem
for the owner of a business experiencing a downturn.


You have no equity until you decide to purchase the equipment at the end of the
lease term, at which point the equipment may have depreciated significantly.


Although you are not the owner, you are still responsible for maintaining the
equipment as specified by the terms of the lease.

Finance Lease

Fixed-term lease, usually noncancellable,
used by businesses in financing capital equipment. The lessor's service is
limited to financing the asset, whereas the lessee pays all other costs,
including maintenance and taxes, and has the option of purchasing the asset at
the end of the lease for a nominal price. It is also called a
full-payout lease because the lease is fully paid out (amortized) over
its lifetime.

Finance Lease

Finance lease, also known as Full
Payout Lease, is a type of lease wherein the lessor transfers substantially all
the risks and rewards related to the asset to the lessee. Generally, the
ownership is transferred to the lessee at the end of the economic life of the
asset. Lease term is spread over the major part of the asset life. Here, lessor
is only a financier. Example of a finance lease is big industrial equipment.

Operating Lease


On the contrary, in operating lease, risk and rewards are not transferred
completely to the lessee. The term of lease is very small compared to finance
lease. The lessor depends on many different lessees for recovering his cost.
Ownership along with its risks and rewards lies with the lessor. Here, lessor
is not only acting as a financier but he also provides additional services
required in the course of using the asset or equipment. Example of an operating
lease is music system leased on rent with the respective technicians.

Importance of Short Term Debt

The short term debts are also called
current liabilities. The current liabilities are outstanding dues that need to
be paid to the creditors, as well as the suppliers. The payments need to be
made within a short span of time. The current liabilities are normally paid by
the companies utilizing their assets.

liabilities

The liabilities refer to the legal
obligations of a company.

The liabilities are an important part of the business of the company as they
are often employed in order to make bigger payments, as well as execute
business activities. The liabilities play an important role in increasing the
efficacy of the business deals being undertaken by companies.

Uses of short term debt

Operating Capital

Operating capital is defined as cash
available to pay for the day-to-day operations of a business. Ideally,
operating capital is available from the revenue generated by business
operations. During the initial period a business is in operation, and at other
times during its existence, revenue may not keep up with operational expenses.
One of the advantages of short-term debt is ensuring that cash is available to
satisfy the operating capital needs of a business. Short-term debt literally is
used to keep a business running during times when the revenue stream
temporarily is insufficient to meet operational needs.

Emergency Funding

There is no way a business owner or
manager can plan for every possible emergency situation. Although a business
ideally maintains a reserve cash fund to at least deal with some expenses
associated with an emergency situation, such an account is not always possible
or funded sufficiently. Short-term debt assists a business in dealing with an
emergency situation, according to "How to Get the Financing for Your New
Small Business" by Sharon L. Fullen. For example, if a piece of equipment
at a manufacturing business fails, short-term debt allows for the replacement
of the hardware.

Expansion

Few business owners start a venture with
the idea that it will remain the same size into the future. Most business
owners desire at least some degree of expansion. Short-term debt provides a
business with ready cash to initiate an expansion program, according to
"Loan Financing Guide for Small Business Owners." For example,
short-term debt is used to lease additional space to house the business'
growing operations.

Advantages of short term debt

Quick Repayment

Short-term loans give borrowers the
opportunity to purchase a new item quickly and to pay it off quickly as well.
This limits the overall interest expense incurred by the borrower and allows
him to quickly build equity in the item. Additionally, if the item is a
depreciating asset, such as an automobile, the short repayment allows the
borrower to repay the debt before the asset is worth less than the balance of
the loan.

Advantages of short term debt

Flexibility

Short-term loans, such as credit cards and
lines of credit, tend to be the most flexible modes of lending available on the
market today. Each allows a borrower to purchase items at her own discretion,
without needing lender approval. Additionally, the balance can be charged up
and paid down and charged up again, as the borrower desires.



Advantages of short term debt

Less Paperwork and Fees

With short-term notes, significantly less
paperwork is needed to process the debt. For example, a credit card merely
requires an application in most cases, with no backup documentation. A
mortgage, however, requires an application with backup documentation including
tax returns, bank statements and pay stubs. Additionally, there are few fees associated
with the opening of a short-term loan, other than nominal opening fees in some
cases. However, with a mortgage debt, the fees average between 3 and 6 percent
of the loan amount.

No interference in management

The lenders of short-term
finance cannot interfere with the management of the
borrowing Sources of Short term Finance concern. The
management retain their freedom in decision making.

Advantages of short term debt

May also serve long-term purposes : Generally business firms
keep on renewing short-term credit, e.g., cash credit is granted for
one year but it can be extended upto 3 years with annual review.
After three years it can be renewed. Thus, sources of short-term
finance may sometimes provide funds for long-term purposes.

Reasons for using long term debt

In the modern economy, a common thread
often links individuals, nonprofits, businesses and government agencies: the
need to find cash to finance short-term activities, but also the urgency to
raise money for long-term financial stability. Perhaps the overarching factor
in using long-term debts comes from the fact that these liabilities give
borrowers peace of mind in the short term. Debtors can then focus on what
matters the most: making money to grow operating activities and be financially
stable to repay long-term debts. Using long-term debt is also advantageous in
the sense that a borrower can lock in a fixed interest rate in the short term,
a situation that might prove profitable if the cost of money rises in the
future.

External Factors

External factors, which mainly relate to
the state of the economy, affect the use of long-term debt. Things like
conditions on credit markets and investors' risk appetite affect the way
consumers and businesses evaluate their future economic prospects. Monetary
policies that financial regulators -- such as the Federal Reserve -- promulgate
also have an impact on interest rates and the money supply in the economy.

Internal Considerations

Internal factors play a key role in
determining a borrower's propensity to use short- or long-term debts. For
example, the prospective debtor's financial situation may encourage the
borrower to seek a long-term loan. If the borrower has a good credit score and
excellent solvency ratios but is facing a temporary cash crunch, a long-term
loan may be the ideal solution.

Business Appraisal by Discounting its Cash
Flow

This offers some useful insights:

You can use the current year's
business earnings and earnings growth rate as your business
valuation inputs.

The capitalization rate is
just the difference between the discount rate and the business
earnings growth rate.

Sources of short term debt

If business earnings vary significantly
over time, your best bet is to rely on discounting when
valuing a business. Since you can make accurate earnings projections only so
far into the future, the typical procedure is this:

Make your business earnings projections,
e.g. 3-5 years into the future.

Assume that at the end of this period
business earnings will continue growing at a constant rate.

Discount your projected business earnings.

Capitalize the earnings
beyond this point. This gives you the so-called residual or terminal
business value.

benefits from factoring
The level of benefit from factoring will vary from business to business.
But it usually provides:

* Immediate cash-flowaccess to 70-90 percent of the value of
debtor invoices.
* Working capital for growth without requirements for a strong
balance sheet or substantial net worth.
* A good interface with the supplier and, as a result, a seamless
transaction for the customer.
* Outsourced debtor administration and associated cost savings.
* The ability to increase sales by offering credit which the
business may have been unable to fund otherwise.
* The ability to take advantage of creditor discount terms,
improve credit rating by being able to pay creditors promptly and an enhanced
ability to capitalize on larger orders as required.
* The option to free up property from being tied as security.